How to use relative valuation of stocks
Beginner Stock Market Investing, Stock Market Investing Advice
The basis of all value investing is to determine a “fair price” for a stock and then to examine whether the stock is overvalued or undervalued in relation to this fair price. One way to identify buy and sell opportunities is to use the technique known as relative valuation to identify attractive investment opportunities at low prices. Professional investors use ratios such as the P/E ratio and the price to book value ratio to try and identify these companies and the relative valuation enables them to compare companies and thus buy and sell appropriately.
The concept of relative valuation is straightforward and consists of trying to establish a value for a company by examining how similar companies are valued in the stock market. The process consists of selecting comparable companies (who will often be in the same industry) and establishing their market values. These values are then converted into multiples such as Price/Earnings and Price/Book Value. The multiples for your target company are then compared to these multiples and it is comparatively straightforward to establish the relative overvaluation or undervaluation. You can then decide whether you want to buy or sell. The simplicity of the method lies in the fact that all the key financial data is readily available and you do not have to make any other assumptions.
The problem with relative valuation arises because multiples are a relatively simplistic method of valuing the company. Consider the following example. Company A reports a dramatic improvement in earnings for a particular quarter and, naturally, the share price skyrockets. As a result, the P/E ratio will also climb dramatically to a level that is much higher than the competition. Because the competition now looks cheap, it is not necessarily a good buy. Competing companies can trade at lower multiples for all kinds of reasons. Sometimes, they may be genuinely undervalued but, more often; this may be because of a faulty business model or sub optimal operations. Stocks may be dirt cheap because the companies concerned are on the verge of closing down or filing for insolvency.
Stocks that appear to be really cheap or inexpensive always have to be viewed with a great deal of suspicion. You should not get carried away by the mathematics of multiples and ignore the basics such as financial information and the future outlook. There is normally good reason for a company to be regarded by investors as not particularly promising especially if the sector to which it belongs is overvalued as a whole. If you go overboard on relative valuation, you tend to ignore the fundamentals of the stock such as its style of operation and its business methods and you could end up losing money.
The only way you can avoid the shortcomings of relative valuation is to put in a lot of homework. You should be particularly careful in compiling the list of comparable companies because this is the platform on which the entire exercise rests. You should preferably use companies that are in the same business and also have similar fundamentals. Because there are other tools that you can use, you should also use other valuation methods to confirm the findings of the relative valuation. Only then should you proceed to trade on the basis of your analysis.
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